A new study from Scientific Beta and Scientific Analytics has identified the risks of making changes to factor indices.
The new paper examined the lack of consistency in factor indices and what risks of the index changes meant, with possible implications being inconsistent factor definitions, factor selection and portfolio construction principles.
Another danger arising from those inconsistencies was the common methodological changes in the industry, which could potentially lead to striking differences in the performance of multi-factor indices, the paper said.
Additionally, the other problems identified by the study included inconsistencies across time with data-mining risks and therefore the absence of any reliability of the performance presented.
According to Scientific Beta’s chief executive, Noel Amenc, index providers should put stringent requirements on index changes to remain consistent with their investment principles.
“Indeed, if the urge to 'innovate' means deviating from investment principles that were not really justified by serious research and corresponded more to approaches driven by in-sample back-testing, there is a risk that index investors will be disappointed with results,” he said.
“Maintaining investment discipline by adhering to a set of long-term principles may be the best safeguard against negative surprises with factor indices.”